Hold-to-Maturity is the new Mark-to-Myth: James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) - Paulson and Bernanke's 'Hold-to-Maturity' plan is really just the new 'Mark-to-Myth', and even its heroic proportions are not likely to paper over solvency problems in the banking system.

The Federal Reserve Chairman told lawmakers the plan to spend $700 billion to buy up bad assets would allow banks to avoid unloading loans at fire sale prices.

"Auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets," Ben Bernanke said, trying to persuade a skeptical Congress that the plan he has been pushing along with Treasury Secretary Henry Paulson will give value for taxpayers' money.

Banks are forced to mark their assets to market, a process that has become increasingly painful and likely to lead to bank failures as a shortage of investors and the swiftly declining performance of the underlying collateral have driven prices lower.

As many securities are so complex that they seldom trade, and given that few want to buy them now anyway, banks sometimes must mark the assets according to modeled prices, a process sometimes referred to as 'marking-to-myth' by doubters.

"Now what the hell is a 'held-to-maturity' price, and how in the world can an auction or 'other mechanism' be devised that gives the market a good idea of 'hold-to-maturity' prices -- since there is no such thing?" economist Thomas Lawler, a former Fannie Mae portfolio manager and founder of Virginia-based Lawler Economic & Housing Consulting, wrote in a note to clients.

"Of course, everyone knew what he meant: 'held-to-maturity' means 'above market.'"

The hope, presumably, is that the subsidy given by buying up debt for more than it will fetch on the open market will be enough to prop banks and attract new investors.

If it is a subsidy, what not call it one?

And though $700 billion is a lot of money, it is not enough to wipe the slate clean and leave banks with workable balance sheets; the plan only works if that $700 billion, which equates to far less in terms of capital relief, is leveraged by attracting new money from outsiders now sitting on the sidelines.

But I find it hard to credit that the sovereign wealth funds of the world, having already been burned though their disastrous investments in banking last year and this, will feel that a price arrived at through what promises to be an opaque process gives them the confidence to buy in now.

"It is hubris to say they are going to set the prices and everyone will just mark to market their assets accordingly," said Tim Brunne, a credit strategist at Unicredit in Munich.

GARBAGE IN, GARBAGE OUT

One possibility being discussed is a reverse auction, where banks will compete to sell bonds to the government. Given that private label securities are often unique, that may be a very difficult process to do in a competitive and transparent way. And seeing as how the purpose of the exercise is in part establishing a mark for banks to use on their portfolios, there is scope for collusion.

If banks do compete and bid down the prices of debt instruments the authorities may be faced with another round of failures, as ailing banks are forced to use new marks and find their capital wanting in the new light.

Alternatively, the government, which has bottomless pockets and no liquidity risk, may simply arrive at a price based on what it, or its advisors -- and one wonders who they could be and if they saw this whole disaster coming -- think is a fair bet on what repayment flows will be.

There is also the issue of protecting the taxpayers, who may justifiably argue that they should share in the benefit of any subsidy offered to the industry in return for footing the bill.

But taking equity stakes in banks in exchange for below market funding or asset sales probably would, as it did with Fannie Mae and Freddie Mac, choke off any hope of new equity infusions from actual investors seeking profits.

It's easy to understand why the United States is placing a low value on moral hazard and is considering an apparently indiscriminate reward for those who took too much risk.

The stakes are very high, and a disorderly deleveraging will be worse than an orderly one, even if the orderly one isn't perfect.

The debate about what whether or not the U.S. will need a massive intervention of public capital into its banking system and wider economy is over. The crisis requires a huge outlay of public funds, both to clean up after the many banks that will fail and to soften the blow to homeowners and consumers.

Banking is a confidence game, even if done soberly and responsibly. But this plan, because it fails to meet the issue of insolvent and failing institutions head on, is not likely to work.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --

(Editing by Ruth Pitchford)